More misery in cards as hurricane season kicks off

Commentary: Residents, investors could be hit hard again

By

EricHolthaus

NEW YORK (MarketWatch) — Americans have endured more than enough dangerous weather over the past several months: huge snowstorms, massive Mississippi River flooding, the worst drought since the Dust Bowl, and a devastating tornado season that’s still on record pace.

Reuters

Satellite view of Hurricane Earl over the Caribbean last August.

What else could possibly happen? Well, hurricane season officially starts tomorrow in the Atlantic. And the potential risks extend beyond those people living in the path of storms to businesses and investors everywhere.

Figuring in the Japanese earthquake and tsunami, global insured-disaster losses are also on record pace, having already passed $50 billion this year, according to insurance broker Aon Corp.
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Extreme weather typically accounts for about 60% of global insured losses — a majority of that coming from hurricanes. Weather-sensitive businesses — such as the insurance industry — won’t have much of a break from extreme weather before hurricane season starts.

Early forecasts are pointing toward a year that could be well above average. In fact, the National Weather Service is forecasting a near “hyperactive” season, a designation reserved for seasons with the top destructive potential. Estimates of the expected number of named storms range from 12 to 18, with five of these being major hurricanes. See full story on the NOAA hurricane forecast for 2011.

There are a few twists to this year’s forecast — some good, some bad.

The good news first: One of the most studied weather and climate patterns is the El Niño pattern, a warming of the tropical Pacific Ocean that occurs once every three to five years. The connection between the power of Atlantic hurricanes and El Niño is well known to meteorologists.

Several El Niño forecast models are beginning to agree it’s looking more and more likely that this year could end up being an El Niño year. If that were to occur, it’s less likely that we’ll have a superactive hurricane season in the Atlantic. However, other areas like the western Pacific, near Japan, would see more.

Now for the bad news: Computer forecasts made around this time of the year are notoriously tricky, so some forecasters turn to “analog years” — past years whose the weather patterns look similar to current conditions — to figure out what may lie ahead.

The International Research Institute for Climate and Society has identified four analog years that may fit our current situation. Despite strong El Niños in two of them, all four years had average or above-average hurricane seasons. One of the analog years was 1999, which East Coasters will remember for Hurricane Floyd — one of the costliest storms in U.S. history.

Hurricane Karl buffets the port of Veracruz, in Mexico, last September.

Another piece of bad news is that weather forecasters are expecting warmer-than-normal ocean temperatures in the Atlantic to continue, at least for the beginning of the season. Warm water is the fuel source hurricanes need to grow.

A third concern — and perhaps the most daunting — is that the Atlantic steering currents that last year were keeping storms out to sea are this year pointing directly for the East Coast. Forecasters at Colorado State University are giving East Coast residents a 48% chance of seeing a major hurricane landfall this year, versus 31% in a typical year.

Three bad-news items for each good one is not a good sign.

Should this season turn nasty, you may wish you had done something about it now. What options do investors with interests in the East Coast have to protect themselves during this year’s hurricane season?

In a year like this, if I owned a hotel complex on Miami Beach, or a grocery store on Cape Hatteras, I’d want to consider possibly hedging that risk as a supplement to regular property insurance.

In 2007, the CME Group launched publicly traded hurricane futures. Since then, the diversity of and interest in the hurricane-hedging contracts have grown significantly.

Scenes from ravaged Midwest

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Raw video depicting scenes from storm- and tornado-hit towns in Minnesota and Missouri.

The basic product for individual storms is a simple yes or no — a so-called binary option. If the hurricane makes landfall anywhere along the U.S. East Coast, from Mexico to Canada, the purchaser receives $10,000 on a premium of about $1,000. If not, the premium is lost. Contracts are offered for each name on the National Hurricane Center’s storm-name list, starting in 2011 with Arlene.

A more complex contract for individual storms takes a combination of storm strength and size at landfall and pays $1,000 per point on the CME’s
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own ratings scale. Purchased far enough in advance, each contract typically costs between $1,000 and $2,000. For reference, Hurricane Katrina scored a 19 — and would have paid $19,000. Read more about Katrina and other hurricanes in MarketWatch Topics.

However, CME’s most popular products are seasonal hurricane contracts. These contracts can be purchased for any of seven coastal geographies, such as Florida, the Northeast, or the oil producing/refining zone from Galveston, Texas, to Mobile, Ala. That way, users don’t have to pay for coverage against storms hitting places outside their area of interest. A seasonal contract will protect the owner against repeated hurricane landfalls over one specific stretch of coastline.

By bringing hurricane hedging onto a publicly traded market, the CME is launching a discussion between individuals or companies holding an asset they want to protect from hurricane risk on one side and meteorologists or speculators on the other. The result — in theory — is lower prices for hurricane protection.

Speculators like hedge funds are interested because there should be absolutely no connection between a weather phenomenon (like the behavior of a hurricane) and a well-diversified investment portfolio. Hurricane forecasts drive this market, not exchange rates or oil prices. Therefore, many hedge funds have hired their own meteorologists in an attempt to make extra money, adding liquidity to the market.

Large regional utilities, oil and gas firms, and investment banks are interested mostly in hedging the risk of fluctuations in energy demand and supply. Citigroup
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for example, has a weather desk focused primarily on trading weather derivatives like the CME hurricane contracts in an attempt to balance out the firm’s overall portfolio.

The head of Citi’s weather desk in Houston, Jeff Manna, focuses primarily on weather’s impact on the oil, gas and electricity-generation sectors. Manna agrees with other meteorologists on the chances of a building El Niño this year.

“I expect that the forecast number of storms for the Atlantic will go down as we get closer to the season,” he says. “But the presence of a persistent trough off the East Coast should create more landfalls this year than last year.”

From Manna’s perspective, a hurricane hitting the East Coast wouldn’t do a whole lot to move energy prices, and could even cause them to drop temporarily as customers tend to use less electricity on cool, rainy days in the summer months. Long-lasting power outages would also decrease demand.

But most of us aren’t energy companies. For property owners or investors, signs are more ominous.

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